Thoughts on business school, economics, NC State, and everyday life from an economist at NC State's business school

Tuesday, June 22, 2010

Mankiw on fiscal policy

Harvard professor and former Bush economic advisor Greg Mankiw has written a balanced assessment of economic policy over the last three years for National Affairs. Mankiw makes a great analogy between the practice of economics and medical practice. The patient is very sick with a combination of symptoms that has not presented itself in the past. There is no time to do a clinical trial; decisions must be made quickly and adjusted as needed depending on how the patient responds.

The economists in the Obama administration decided to treat the patient according to a textbook published in 1936 by Dr Keynes. Mankiw points out that more recent economic research, some done by some of the President's own economic advisors, calls Dr Keynes' approach into question.

Macroeconomists especially have good reason to be humble, for there is a great deal we do not know. Teaching the "Principles of Economics" course at Harvard — a full-year survey — I start each year with what we economists are confident is true, and then move to material that is less and less certain as the course progresses. We look first at supply and demand, the theory of comparative advantage, profit maximization, and marginal revenue equaling marginal cost — the premises that almost every economist shares and accepts. As the course goes on, we move from micro to macroeconomics: examining classical monetary theory, growth theory, and, at the very end of the year, the theory of business cycles. This is the topic we economists understand least of all: We are still deeply divided on the validity and utility of the basic Keynesian paradigm. But it is precisely the topic that government macroeconomists work on most, especially during times of recession.

Even as a believer in many aspects of Keynesian theory, I appreciate that one cannot approach this subject matter without showing some humility. Economics is a young science, and much of our knowledge is necessarily tentative. Humility need not result in resignation or fatalism; nor does it mean we can't make economic policy. But it should mean that we constantly test our assumptions and policies against real-world results.

Mankiw questions, as do I, the decision to stimulate the economy mainly through government spending as opposed to tax cuts. There is a long lag (often more than a year) between the time extra spending is authorized and the time the dollars actually hit the economy. In contrast, tax withholding tables can be changed within a month or two. One also has to question the lasting value of much of the extra spending -- it makes a big difference whether we are making investments (e.g., GI bill, interstate highway system) or not.

The article goes into a lot of detail about recent research on fiscal policy and ends with a quote from Milton Friedman:

The role of the economist in discussions of public policy seems to me to be to prescribe what should be done in light of what can be done, politics aside, and not to predict what is ‘politically feasible' and then to recommend it.

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Steve Allen is Associate Dean for Graduate Programs and Research in the College of Management at NC State University. He has appointments in the Department of Economics as well as the Department of Management, Innovation, and Entrepreneurship. Steve also is a Research Associate of the National Bureau of Economic Research, a non-profit research organization located in Cambridge, Mass.